Q1 2018 Municipal Credit

Author: Patricia Healy, CFA, Post Date: March 30, 2018

Ratings, Teachers’ Strikes, Pensions, Higher Education

During the quarter, Moody’s and S&P reported that upgrades of municipal bonds continued to dominate downgrades in 2017. For S&P it was the sixth year in a row, with California leading the way in the number of upgraded issuers, followed by Florida and Texas. For Moody’s it was the third year in a row that upgrades surpassed downgrades. Moody’s noted, however, that the dollar amount of downgrades did exceed that for upgrades. The downgrades of New Jersey, Illinois, Connecticut, Puerto Rico, and related issuers accounted for almost 70% of downgraded debt. As our readers know, we have avoided the mentioned issuers’ bonds – except for selected insured bonds of Puerto Rico. Overall, the positive ratings environment is expected to continue with projected economic growth, although S&P notes that the tax reform limits on the deduction of interest for mortgages larger than $700,000 could constrain home prices in high-cost places like California (limiting the flexibility to raise property taxes); and the cap on federal deductions for state and local taxes could also produce stress in high-tax states, thus limiting upside ratings movements and potentially resulting in downgrades. Notwithstanding the positive growth, outlooks show that pockets of weakness are expected to remain in healthcare and higher education.

State Ratings

We noted in our last quarterly municipal credit commentary (https://www.cumber.com/q4-2017-credit-commentary-taxes-pensions-ratings/) that state rating activity had waned; and now the first quarter of 2018 is the first quarter in at least seven when there was no rating action on any state by Moody’s, S&P, Fitch, or Kroll; and that includes trend changes.

There was plenty of state news, however, focused on teachers’ strikes.

The West Virginia teacher’s strike closed all schools in the state for nine weekdays ending March 6th. The teachers prevailed and secured a 5% pay increase for public employees and a pledge to review healthcare coverage. The raises will likely come from reductions in other services. Oklahoma teachers have a strike planned for April 2nd, and although the state did grant a pay raise to public employees on March 26th, as of this writing the strike has yet to be called off. The pay increase will be funded by increasing taxes on oil and gas production, hotels, tobacco, diesel fuel, and gasoline. Arizona teachers are looking for pay raises, too, and a strike could be on the horizon after teachers’ success in West Virginia. There are also rumblings from teachers in Kentucky, who are worried about potential changes to their health and pension benefits. K–12 education is one of the largest spending items for states, second only to Medicaid, though it declined from 22% of states’ spending in 2008 to 19.4% in 2017, according to a report by the National Association of State Budget Officers. Overall spending on education increased 3.9% in 2017; however, the growth in Medicaid spending was 6.1%.

Pensions and OPEB 

Wages are only one form of compensation that public teachers receive. They also receive pensions and other post-employment benefits (OPEB) such as healthcare. For the past three years, governments have been required to report pension liabilities in greater detail, with historical information and illustrations of how their pension liabilities will change with changes in assumptions (such as a 1% change in the discount rate). As we have commented in the past, the lowering of the discount rate increases a future pension liability and raises the annual amount that must be paid into the pension plan to keep the liability from growing further. This factor is important, as the funded level of many plans is below 100% and the average was just 72% for fiscal 2015, as reported by Pew Charitable Trust. According to the Government Accounting Standards Board (GASB), accounting standards 67 and 68 are designed to improve the decision usefulness of reported pension information and to increase the transparency, consistency, and comparability of pension information across state and local governments. Starting in fiscal years ending June 30, 2017, GASB statements 74 and 75 require similar reporting of OPEB obligations. Although OPEB obligations are less contractual than pension promises are, they are not politically easy to reduce, and they are generally lower-funded or not funded and paid on a pay-as-you-go basis.

Reducing benefits is one way governments have been trying to reduce growth in unfunded liabilities. As governments are challenged by the decline in the ratio of current employees to retirees, as well as by competing demands for resources, the greater transparency required by GASB is welcome to analysts and stakeholders alike.

Speaking of Education

In February, Moody’s published an article, “Declining international student enrollment dampens US universities’ tuition revenue growth,” that cited two studies showing declines in international student enrollment. The Council of Graduate Schools found that international undergraduate applications declined by 3% and enrollment at the graduate level fell by 1% in 2017, reversing a decade-long expansion. In a January report, the National Science Foundation (NSF) found that international undergraduate enrollment declined by 2.2% and international graduate student enrollment declined by 5.5% 2017. Variations in the two studies are attributed to the different samples used. International students generally pay full tuition; and although international students account for less than 5% of overall enrollment, they represent good business in the margin. Declines were most noticed in schools with less brand recognition and in non-research-intensive programs. The NSF report concludes that the effect of new immigration policies, changes to visa regulations, and uncertainties around job opportunities post-graduation may continue to hamper application and matriculation rates of international students over the next several years. In January 2017 we noted the potential risk to higher education in a commentary “Higher Grounds for Higher Education” (https://www.cumber.com/higher-ground-for-higher-education/) and emphasized that our strategy is to invest in larger, well-established institutions with strong demand characteristics.

Notwithstanding the international student effect, increased competition due to declining student populations and ever-rising tuition costs have caused some smaller private colleges to struggle financially. In an early March article, Bloomberg noted that these challenges have led to some schools merging with each other or being absorbed into larger institutions. There were at least 55 merger and acquisition transactions among colleges and universities between 2010 and 2017. The Northeast is particularly affected since it has a high concentration of colleges while the number of high school graduates is expected to decline. A number of years ago we decided to avoid small private colleges noting declining enrollment trends, higher costs, and increased competition from public institutions.

Cumberland is sponsoring the second annual Financial Literacy Day on April 5th at the University of South Florida Sarasota Manatee campus. The event is open to public participation. All are invited and welcome. You can make your reservation online and learn more at https://www.interdependence.org/events/second-annual-financial-literacy-day-update-financial-markets-economy/.

Patricia Healy, CFA
Senior Vice President of Research and Portfolio Manager
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